Fed Funds Explained No. 3

Banks Replace Gold and Introduce Fractional Reserves

This post tells a short tale of how banks take ownership of gold (a money commodity) and replace it with notes and checking accounts used as money. Eventually, they create more checking account money than they have gold, creating “fractional reserve banking.”

New Account

In a time before the creation of The Federal Reserve System, a man walked into a bank with a 10-pound bag of gold. He told the teller he wanted to open a deposit account in exchange for a few bank notes and a checking account. The teller told him he could exchange the bank notes or a check drawn on his account for goods at any store in town. When the merchants brought the notes on checks to the bank, they could exchange them for the amount of gold designated on the negotiable instruments.

Gold – Money Exchange

As the man was leaving the bank, he told the teller to take care of his gold. The teller politely stopped the man and explained that the gold did not belong to him; it belonged to the bank. That’s why the bank listed it as an asset on its accounts. He also told the man not to worry. The bank always kept more than enough gold on hand to honor all of the bank notes and deposit liabilities at the same time. They referred to the gold they held to pay notes and checks as “reserves.”

This man went on a small shopping spree and paid for all his merchandise with his new checks.

Bank “Deposits”

When the store owners took those checks to the bank at which they also had accounts, they did not ask to withdraw gold. Instead, they asked the bank to credit their accounts.

In response to those requests, the bank subtracted the amounts from the man’s account (destroying that money) and added an equal amount to the stores’ amounts (creating new money.) Thus,” transferring” money from one bank customer to another referred to destroying (expunging) money in the form of bank liabilities and creating new money in the form of liabilities to other customers. Only occasionally would a customer bring in a check and arks for gold.

Fractional Reserves

Some time along the way, banks figured out that they were making all these money transactions without much gold being taken from the bank. They figured they could buy promissory notes from some customers by simply creating new money in the form of checking account balances. By doing this, the gold reserves became a fraction of their checking account liabilities. Thus was born” fractional reserve banking.”


Banks own the gold held as reserves.

Banks create money when providing checking accounts.

When banks create new money (as checking accounts) equal to more than the amount of reserves, we call it “fractional reserve banking.”

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